Fin571_Wk_4_Guillermo

Guillermo Week Four Case Summary Guillermo owns a hand-carved furniture store in Sonora, Mexico, which reaps the benefits of inexpensive labor and easy availability of the necessary materials (i.e. lumber). Guillermo earned a decent profit on his furniture sales, in part, through paying standard low wages. However, recent changes have reduced Guillermo’s profits. In addition, an overseas competitor employed an expensive high-tech automated system that produced a high-efficiency, low-cost production method, which cut the cost of items identical to those that Guillermo had crafted. Guillermo does not want to acquire or be acquired by another company or acquiring another company. Instead he is considering a partnership. Guilllermo felt that he could convince this company to allow him to distribute their product, while still maintaining some of his own furniture production. Introduction In order to gain market share and profit in an evolving market, Guillermo must make informed investment decisions. To that end, he is faced with a choice of three alternatives: (1) maintain the currently used approach; (2) invest in the high-tech approach; or (3) broker merchandise from the larger manufacturer. Guillermo most easily can forecast costs using the current approach. However, as he has noted a drop-off in sales while implementing this method, it is likely that this approach needs to be modified. The high-tech approach can be used to increase production by 50%, but it involves an expensive up-front investment and an increase in direct labor costs, plant overhead, and income tax expense, relative the current method. The broker approach also will increase production levels; however, Guillermo will pay an opportunity cost of prioritizing the manufacturer’s product over his own. In addition, many of the same costs that increase using the high-tech approach also do so using the broker approach. Guillermo must compare the three available options systematically to increase the probability of sustaining his business. To do so, he should employ a capital budget that considers the Weighted Average Cost of Capital (WACC) and Net Present Value (NPV) for each option, to help him increase his firm’s value (Emery, Finnerty, & Stowe, 2007). Weighted Average Cost of Capital (WACC) WACC refers to the “current required returns on debt and equity, where the weights are the market-value proportions of debt and equity in the firm’s capital structure (Emery, Finnerty, & Stowe, 2007),” and is calculated as: Where E = equity financing; D = debt financing; re = required return for equity; T = marginal corporate tax rate; rd = required return for debt; L = market value proportion of debt financing (Emery, Finnerty, & Stowe, 2007). When assessing WACC for capital budgeting in the same business, L may be simplified to the proportion of debt:assets. For Guillermo, this translates to $1,130,963/(1,342,074), or 0.84. Guillermo’s tax rate is 0.42. With the appropriate rate information, Guillermo could decide which option had the optimal WACC, and select that project. Lower WACC refers to lower required return to investors and lower project risk. However, as greater risk may lead to greater returns, the lowest WACC is not always the most optimal. Guillermo should leverage the amount of risk and the time to required return with his desired profit to make this decision. Internal Rate of Return The internal rate of return (IRR) refers to the expected return on a project. A project should be undertaken if the IRR is greater than the cost of capital associated with said project. IRR refers to the discount rate at which the NPV of expected cash flows is equal to 0. Typically, when the IRR is greater than the cost of capital, the NPV of the project is positive. However, this would not hold if two projects were mutually exclusive and differed in scale. With regard to Guillermo, it is possible that the choice between maintaining his current business practices and investing in high-tech methods would elicit a disagreement between IRR and NPV. IRR may be computed using the following formula: Profitability index, modified internal rate of return, payback, discounted payback, and urgency are other valuations that may be assessed to lessen risk in an investment. The profitability index is used to select projects that offer “more bang for their buck” ((Emery, Finnerty, & Stowe, 2007). This valuation allows investors to forecast their return relative to each dollar invested. Projects should be pursued if they have a profitability index that is greater than 1. Profitability index may be assessed with the following formula: This valuation is inappropriate when two mutually exclusive projects differ in size (Emery, Finnerty, & Stowe, 2007). With the case of Guillermo, the different investment amounts necessary to move into high-tech production, relative to maintaining the current path does not indicate this method. The modified internal rate of return is similar to IRR, but provides a better measure of relative project profitability. This measure calculates the present value of cash outflows and future value of cash inflows using the cost of capital (Emery, Finnerty, & Stowe, 2007). It may be calculated with the following formula: The payback measure assesses the amount of time that it will take for investors to recoup their money. Thus, it reports the point at which the cash inflow is equal to the initial cash outflow. This method suggests that investors pursue the project that takes the least amount of time to regain their investment. This method tends to reject long projects, because risk is increased when payback is expected to be far into the future. For Guillermo, the payback measure would suggest that he select the venture that would recoup his initial investment the quickest. However, it would reject a greater, but more distant, pay-off. Discounted payback refers to the amount of time that it takes for discounted cash flows to equal the initial investment. This measure incorporates the time value of money with the payback method (Emery, Finnerty, & Stowe, 2007). The two payback methods ignore the time-value of money and ignores risk disparities between projects. Urgency refers an immediate need for an investment. It is a poor choice for project selection, and should be avoided by using regular assessment of capital equipment and other needs. With respect to Guillermo, his equipment has depreciated to 0. He should consider investing in new equipment before his current equipment fails, and necessitates the urgency method for investment choices. Net Present Value (NPV) NPV is “the difference between what something is worth (the present value of its expected future cash flows—its market value) and what it costs,” taking into account the time-value-of-money (Emery, Finnerty, & Stowe, 2007). NPV analyses are the most useful data when deciding whether to select a project, whereby a project should be pursued if the NPV is positive and avoided if NPV is negative. However, NPV only can be estimated prior to selecting a project; an accurate assessment cannot be made fully until the project and an accounting of its returns is complete. Guillermo should select the project with the greatest NPV. NPV is calculated as such: (Emery, Finnerty, & Stowe, 2007). Where CF0 = initial investment (typically negative); CFt = cash flow at a specific time-point; r = cost of capital; n = life of project Sensitivity Analysis A sensitivity analysis is “a technique used to determine how different values of an independent variable will impact a particular dependent variable under a given set of assumptions” (Investopedia, 2012). For example, if Guillermo should invest more money in capital equipment, he will see a greater initial cash outflow, but he may see a greater net profit in the long-run. With regard to his three alternatives, if Guillermo continues with his current practices, he will see little increase in his initial costs, but his net income will be only $42,577. If he selects the broker alternative, he will see a slight increase in net income (to $50,955). However, he also will be paying a high opportunity cost in sacrificing the majority of his time to distributing the product of another manufacturer, rather than crafting his own product. However, if he pays the high initial cost associated with the high-tech production method, his net income will increase to $195,564. Therefore, if he can afford/raise the initial investment associated with high-tech production, this is the method that he should choose. References Investopedia US. (2012). “sensitivity analysis.” http://www.investopedia.com/terms/s/sensitivityanalysis.asp#ixzz2DXjEywmC. Accessed 11/28/12. Emery, D. R., Finnerty, J. D., & Stowe, J. D. (2007). Corporate financial management (3rd ed.). Morristown, NJ. Wohl Publishing Inc. University of Phoenix. (2012). “Guillermo’s Furniture Store Scenario.”